Financial Performance Ratios: Profitability Indicators

Video Transcription:

Hello Traders,

Welcome to the stock trading course and the sixth module – investing, stop thinking. In this lesson we are going to talk about financial performer ratios or what I’d like to call profitability indicators. So financial performance ratios will give you an idea of how efficient a company is in returning profits to its investors. These ratios will be used by investors as profitability indicators. So basically what I am going to teach you here on this lesson is how to calculate these ratios to look for the most profitable companies.

So this is the list of profitability indicators. The first one is the return on equity or ROE. This ratio indicates how profitable a company is by comparing its net income to its average shareholder’s equity. In other words, the ROE measures how much the shareholders made for their investments in the company. A high ROE reading indicates that the company’s management is very good at creating profits from money invested. So when you are looking at ROE’s you might want to look at higher than average ROE’s because those companies are the companies that have the higher return on investment. A low ROE indicates the contrary, so the formula for calculating the ROE is net income divided by average shareholder’s equity, times 100. And this is expressed in percentage. If a company or an ABC company reports a net income of $32.5 million over an average shareholder’s equity of $750 million the ROE of this company would be 433%. As a blunt number this ROE doesn’t mean much and has to be compared to previous quarters. This means that if we have a growth in ROE this indicates that management is getting better at returning a profit over money invested. And of course, you can also look at ROEs in sectors. If you want to invest in a sector, let’s say you want to invest in consumer goods, you can look at all the competing companies’ ROEs and decide based on the ROE where you want to put your money in. But remember that this is just one of the three profitability indicators that you are gong to lean on this course.

The second one is return on capitol employed or ROCE. This adds the company’s liabilities to the average stockholder’s equity to reflect the capital employed by the company. So this ratio uses the actual capital employed by the company and not the overall investment on the company. By adding the company’s liabilities, investors can have a better gauge of the company’s ability to make a profit for over invested money. This ratio also uses the company’s earnings before tax and interest or EBTI, instead of the net income. So the ROCE formula is EBTI divided by total capital employed, times 100. This ratio gives investors a better look of how the use of leverage or debt impacts a company’s profitability. So investors look for a higher ROCE than the company’s borrowing rate to decide to invest in a company. If a company has an ROCE lower than a borrowing rate, you should avoid investing in this company.

And the third profitability ratio is the returns on assets. This ratio indicates how profitable a company is relative to its total assets. This ratio indicates how well management is employing the company’s assets to generate a profit for shareholders. So the ROA formula is net income divided by total assets, times 100. And the higher the ratio, the more efficient the company’s management is in utilizing its assets to generate a return for shareholders. So basically, these are the three profitability ratios you are going to use to evaluate the company or a company’s management in its ability to generate a profit for your investment. You’re going to look for high ROAs and ROEs and you’re going to look for a higher ROCE than the company’s borrowing rate.

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